John P. Hussman, Ph.D
As of Friday, the S&P 500 was at about the same level as at the end of February. I noted then that our estimate of potential market losses over an 18-month window was in the worst 1.5% of historical observations. More recently, we’ve observed a marked deterioration in our measures of market internals. As a result, our estimate of potential market losses over a 6-month window is now in the worst 0.5% of historical observations. In particular, we’re seeing a very broad-based downward shift in market action across nearly every industry group. While the depth of the breakdown is still fairly shallow, the uniformity of the signal suggests significant information content (for more on this distinction, see the note on extracting economic signals from multiple sensors in Do I Feel Lucky?). Though our market concerns are independent of our economic concerns, we see essentially the same downward uniformity in leading economic measures across the industrialized and developing world (for example, see the charts near the end of last week’s comment Is the Fed Promoting Recovery or Desperation?).
Of course, our risk estimates are based on the average market outcomes that have followed similar evidence over the past century, and this particular instance may be different. Regardless, I remain in the uncomfortable position of having to express our concerns with the word "warning."
This is not an appeal for investors to sell, or even reduce their investment exposure, but is rather an appeal for investors to carefully examine their exposure to market risk, and to consider their willingness to adhere to their existing investment discipline through a steep and potentially extended market decline. We are enormous advocates of investment discipline, but we also know how uncomfortable that can be during various points of the market cycle. For buy-and-hold investors, the main thing to examine is the extent of loss you can tolerate without abandoning that strategy, in recognition of the actual size of the losses that investors have regularly experienced over time. It is best to ask that question when you are experiencing strength. You never want to be in a position of abandoning a sound long-term discipline because of discomfort over some portion of the market cycle.
I have no desire to persuade investors to abandon their discipline or make major changes to their portfolio allocations if they have considered the potential risks carefully. That consideration should include a careful examination of the declines that stocks have experienced on several occasions since 2000, because as I’ve detailed in numerous prior comments, present valuations are much closer to those that have accompanied historical market peaks than those that have marked durable troughs. In any case, my job isn’t to convince others of our own investment viewpoint or to nudge investors away from their own particular discipline. My job is to articulate our own as clearly as possible, so our shareholders understand what we are doing and why. Right now, we are white-knuckle, hold-on-tight defensive, because we’ve only seen similar return/risk estimates in the left-most tail of the historical data, and the growing number of hostile indicator syndromes we observe have generally been followed by awful market losses.
I’m quite aware that the investing world has ruled out any possibility of extended market losses thanks to the confident certainty that the Fed is capable of preventing both market declines and economic downturns indefinitely. But even in recent years, the best that these massive interventions have done is to provoke about 6 months of speculative advances and a brief burst of pent-up demand – each time only after the market has suffered reasonably significant losses. We may very well get QE3. But to believe that the hope for QE is itself sufficient to prevent significant losses first is a notion that is not even consistent with the evidence of the past few years.
We remain defensive on the basis of an army of hostile syndromes (typified by the "overvalued, overbought, overbullish, rising yields" combination, but coupled with several others), now joined by a breakdown in market internals – not greatly observable on the basis of depth, but of high concern on the basis of uniformity. We also observe clear evidence of economic softening and recession around the world, and an early deterioration in U.S. indicators as well (though these data points are still dismissed as noise). In short, our concern about market risk persists. Our concern about the risk of an oncoming recession persists. Nothing in the recent data has removed my impression that the period ahead may become an unmanageable Goat Rodeo of market volatility, economic disappointments, sovereign debt concerns, and European banking strains. Our risk measures have been less extreme in about 99% of history, so even if they are incorrect in this instance, we are not likely to persist with such a strongly defensive view for long. I expect that we’ll have good opportunities to accept a constructive investment stance at better valuations and without such extensive headwinds. But with the recent deterioration in market internals, we can’t even see a speculative case for market risk here.
In the classic version of Charlie and the Chocolate Factory, Gene Wilder watches one child after another ignoring every cautionary warning, with predictably bad consequences. His deadpan appeals become increasingly halfhearted and emotionless because he knows they won’t listen anyway. We’re strongly defensive based on historical evidence that is in the most negative 0.5-1.5% of all historical observations, but it’s clear that others are willing to take significant market risk and to chase wildly enamored stocks here, not as part of a long-term investment discipline or as part of a balanced portfolio strategy, but simply as a speculation – in the belief that they’ll be able to take their profits before other speculators do. Our only response to these speculators is to quote Willy Wonka: "I wouldn’t do that. I really wouldn’t. No… Stop… Don’t."
As noted above, the Market Climate for stocks remains particularly hostile on the basis of a variety of hostile indicator syndromes – particularly the joint overvalued, overbought, overbullish, rising-yield condition at present – as well as a uniform deterioration in market internals. Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is hedged at 50% of the value of its stockholdings, which is its most defensive stance. In Strategic Total Return, we added a few percent to our precious metals holdings on the selloff early last week. The Fund presently has a duration of less than 3 years in Treasury securities, with about 8% of assets in precious metals shares, and about 2% of assets in utilities and foreign currency holdings.